18 March 2010

How Can We Achieve Audit Industry Reform?

The Sarbanes-Oxley Act of 2002, particularly Title II, which banned the same firm from providing external auditing and other consulting services and imposed requirements designed to make public companies change their auditing firms from time to time, was supposed to have transformed the accounting industry. Mostly, it didn't.

The current public accounting market consists of a “Big 4”, a middle tier and a lower tier. The Big 4 firms are Deloitte & Touche, Ernst & Young, PricewaterhouseCoopers and KPMG. As of the 2003 GAO study, these four firms audited over 78 percent of all U.S. public companies and 99 percent of all public company sales. . . .

[I]n 2003 before any firms were required to be compliant with SOX, 38.8 percent of auditor switches were from Big 4 auditors to other Big 4 auditors while 20.6 percent of switches were from Big 4 to middle tier auditors. In 2004 when the first firms were required to be compliant with SOX, 24.5 percent of switches were from Big 4 to other Big 4 auditors and 29.4 percent of switches were from Big 4 to middle tier auditors. . . . [W]hile only four firms are capable of auditing large multinational firms, more than 1600 firms have registered with the PCAOB as of March of 2006. . . .

This study defines the middle tier to include all non-Big 4 audit firms with 2004 revenues exceeding $250 million, according to Public Accounting Report’s Top 100 for 2004. This definition includes: RSM McGladrey (Minneapolis), Grant Thornton (Chicago), BDO Seidman (Chicago) and Crowe Chizek & Co (Indianapolis). These comprise all non-Big 4 firms with more than 100 SEC clients. All other firms are classified as small tier firms.

This matters a lot, because auditing firms that screw up or misbehave risk a rapid exit from the market of the kind we saw from Arthur Anderson when it was indicted for criminal conduct in connection with the Enron scandal. When you have just four firms that dominate the industry, this is a problem.

Why is the industry so concentrated, despite legal initiatives designed to shake up this situation, and what can be done about it?

Sarbanes-Oxley lead to an across the board increase in accounting fees in publicly held companies, which helped encourage some firms to "go private" or "go dark." Much of this was associated with the initial burdens involved in setting up adequate internal controls under Section 404 of Sarbanes-Oxley. But, as of 2009, accounting fees had been falling again for eighteen months.

This wasn't entirely unexpected. Congress passed Sarbanes-Oxley almost unanimously because of a widespread feeling that sloppy and maleficent internal controls and accounting practices were leading to financial disaster, and Congress wanted to impose more discipline. A short term burst of accounting activity to get everyone on the level naturally followed.

But, why didn't the external audit firms of the Big Four get spun off from their parent companies that mostly engaged in internal accounting and consulting functions and why didn't medium sized firms gain a bigger market presence, freed of the need to be full service behemoths to serve public companies in the narrow external audit function?

Most public companies, after all, aren't large multinational companies. There are 1024 foreign public companies and about 15,000 domestic ones registered with the SEC as of 2008. Of those, only a couple thousand are large multi-national companies.

Mid-sized and small accounting firms ought to be able to handle, at least, the affairs of these 13,000 or so smaller domestic publicly held companies, but overwhelmingly do not. Why?